The last US business cycle, which was ended by the Coronavirus pandemic, was the longest with the lowest real growth and inflation performance since World War Two 1. The Fed did not have to worry much about inflation and could focus on promoting employment and maintaining financial stability.
In our judgment, the unfolding new economic cycle will be different. We expect no 1970s-style stagflation, but inflation will be higher, in our view. For the Fed, this creates a dilemma.
Responding to higher inflation could destabilize financial markets and, thus, the economy, given high levels of public and private debt. Neglecting price pressures could make the inflation problem worse and encourage public and private borrowers to take on more debt.
We believe the Fed will try to control inflation but may shy away when facing financial instability. The result may be a more volatile and a shorter business cycle.
While Corona is not yet fully overcome, the recovery is already leading to a new expansion phase.2 The Pandemic has triggered some changes that we believe will last (e.g., working from home). More fundamentally, we expect three changes that will differentiate the new cycle from the previous cycle.
Source: US Census Bureau3
Source: IMF4
Source: US Bureau of Labor Statistics6
The projections from the last FOMC meeting on September 22nd show the Fed is confident that inflation will moderate significantly in 2022.7 At the same time, the Fed is signaling its intention to begin the process of policy normalization soon.
At the September 22nd meeting, FOMC members projected the first interest rate hike for 2022 (two years earlier than the projections from last March) and Fed Chairman Powell stated at the subsequent Press Conference that a decision to reduce asset purchases (tapering) could be made as early as in the next meeting in November.8
We have no doubt that the Fed will start policy normalization soon, but the question is whether the Fed will be determined to maintain price stability under any circumstances. The projections of current FOMC members imply that policy normalization does not require significant tightening: by 2024, the median FOMC member projects a Fed Fund rate of 1.8% with a Personal Consumption Expenditure inflation rate of 2.1%, which implies still negative real interest rates.9
These projections could mean the Fed believes that not much has changed and that the US economy will remain stuck in an environment of low growth and inflation with low and even negative real interest rates.
As outlined before, we believe the new cycle will be different. Our expectation of stronger investment, little to no efforts to balance the fiscal budget and higher inflation would imply that interest rates have to rise more than what the Fed is currently projecting.
Perhaps the Fed will tighten more if our outlook is correct. However, we believe that financial stability concerns will make the Fed hesitate. Financially stability is not an official Fed target. In practice, however, we think financial stability matters a lot to the Fed.
Crisis situations like the Great Financial Crisis and the initial shock from the Corona Pandemic have shown that the Fed is willing to do all it can to restore financial stability.
Yet the Fed has become sensitive to financial conditions even in more normal times. A good example is the sudden policy shift at the end of 2018 and early 2019.
At the meeting on September 26th, 2018, FOMC members projected 75 basis points further rate hikes in 2019.10 At the meeting on December 19th, 2018, the projection of further rate hikes in 2019 was lowered to 50 basis points amid a decline in financial market conditions.11 Equity markets fell further in the days immediately after the December FOMC meeting12 and the Fed effectively halted its rate hiking program at the next FOMC meeting on January 30th, 2019, citing tightening in financial conditions.13
Maintaining financial stability is not an end in itself. Rather, maintaining financial stability has become important because of the growing links and feedback loops between the financial sector and the real economy.
The key link between the financial sector and the real economy is debt. With the rise of debt, financial instability risks having large negative effects on the economy through the unraveling of credit links and conditions as well as defaults.
Another important link is the rising equity market capitalization. Financial instability can create significant negative wealth and balance sheet effects with painful feedback loops for the real economy.
Financial stability was not a primary concern when the Fed tightened policy in the late 1970s and early 1980s to combat inflation. Back then, total debt in the economy was just about 150% of GDP, today it is more than 350% of GDP (see chart 4). Similarly, equity market capitalization was just 40% of GDP, today it is around 330% of GDP (see chart 4, again).
Source: Board of Governors of the Federal Reserve System and US Bureau of Economic Analysis14
In our view, financial markets are aware of the financial vulnerabilities of the economy. So far, financial markets seem comfortable with the Fed’s policy projections as they do not imply a departure from the low interest rate environment of the last cycle.
This may change quickly, if the Fed signals that it is prepared to tighten more, as was the case in 2018. However, financial markets have also learned that the Fed is likely to pull back when financial conditions deteriorate. By this logic, financial markets may get comfortable that the Fed will never seriously tighten policy and rely even more on easy financing conditions.
For the government, debt sustainability depends critically on the continuation of the low interest rate environment. The Congressional Budget Office (CBO) currently projects an average 10-year Treasury rate of 2.3% over the next 5 years with real growth and inflation at 2.1% and 2.2% respectively.15 Under these favorable conditions (nominal growth exceeds interest rates by a large margin), the CBO expects the Federal debt as a share of GDP to remain relatively stable despite a significant primary (non-interest) deficit.16
However, the CBO’s long-term budget outlook also shows that the debt to GDP ratio will double within 20 years to over 200% if the government fails to reduce the primary deficit and the 10-year Treasury rate gradually rises to 5%.17 A 10-year Treasury rate of 5% seems high from today’s perspective, but was at the low end of the range in the 1970s through the 1990s.18
It would be wrong to think the Fed will not try to do the right thing. However, the trade-off between inflation control and maintaining financial stability may be very difficult or impossible to overcome.
We believe the Fed will end up with a muddling through approach, shifting priorities between inflation control and maintaining financial stability depending on which side of the problem is acutely bigger. The resulting risk is that more frequent shifts in monetary policy will result in more financial and economic volatility.
One area where the volatility could increase markedly is the yield curve. The yield curve is likely to steepen sharply if the Fed stops buying assets or even unwinds some of its security holdings yet treads carefully on the interest rate side and allows inflation to run higher. On the other hand, any signs that the Fed will be a bit more aggressive in fighting inflation could quickly trigger recession fears and result in yield curve flattening as was the case in late 2018 and early 2019.19
In our view, rising financial and economic volatility reduce the life expectancy of the business cycle yet fail to stop the rise of debt in the economy if financial markets do not think the Fed is determined to resist inflation at any price, preserving debt-friendly financing conditions.
As always, we are available to discuss our views with you. Please contact your Client Relations representative at +1 732 978 9722 or zais.clientrelations@zaisgroup.com
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